APY vs APR – what’s the key differences?
When researching decentralized finance (DeFi) products, you may have come across these two similar-sounding terms, APY and APR.
When you invest in a digital money account, the APY, or annual percentage yield, incorporates interest compounded quarterly, monthly, weekly, or daily, while the APR, or annual percentage rate, does not.
It is therefore crucial to comprehend how these two measurements are calculated and what impact they have on your long-term returns.
In this article, we are going to explain the two measurements in great detail.
APY vs APR: What’s the difference?
The annual percentage rate (APR) and annual percentage yield (APY) are both critical for personal finance. Let’s begin with the simpler term, annual percentage rate (APR).
Annual percentage rate (APR)
APR refers to the interest rate a lender earns on their money—and that a borrower pays for using it—over a one-year period.
If you invest $10,000 in a bank savings account with a 20% APR, you will earn $2,000 in interest after one year, for example. Your interest is calculated by multiplying the principal amount ($10,000) and the APR (20%). After one year, you will have a total of $12,000, after two years, $14,000, after three years, $16,000 and so on.
Annual percentage yield (APY)
Before getting into annual percentage yield (APY), let’s first understand what compound interest is. Compound interest is simply earning interest on prior interest. If the bank pays interest to your account monthly, each of the twelve months of the year will result in a different balance for you as a result.
Instead of receiving $12,000 at the end of the 12th month, you will receive some interest each month. Each month, your deposit’s principal sum will be increased by the interest accrued, and the sum on which you earn interest will be higher. Each month, you will have more money earning interest. This effect is called compounding.
Suppose you invest $10,000 in an account with a 20% APR, with interest compounding monthly. Without getting into the complex mathematics, you would end up with $12,429 after one year. That is $429 more interest earned by including the effect of compounding interest. If you had an interest rate of 20% but interest was compounded daily, how much interest would you earn? You would earn $12,452.
A daily compounding product with the same 20% APR would leave you with $19,309 after three years. That is $3,309 more interest earned than the same 20% APR product without compounding.
You would earn a lot more if compound interest were incorporated. The interest rates vary according to compounding frequency. Compound interest is more beneficial when it occurs more frequently. Compounding occurs daily rather than monthly, resulting in higher interest.
What is the annual percentage yield (APY) of a financial product that provides compound interest?
It’s how much you can make using a formula to convert an APR to an APY depending on compounding frequency. With monthly compounding, 20% APR generates an APY of 21.94%. With daily compounding, it would provide an APY of 22.13%. These APY numbers reflect your annualized interest return after including compound interest.
The APY (annual percentage yield) is a more dynamic and complicated metric. It’s always quoted as a static annual percentage rate.
Interest earned on interest, or compound interest, is included in the APY but not the APR (annual percentage rate). Compounding frequency determines how frequently the APY changes. To remember the distinction, think of the five letters in ‘yield’ (one more than ‘rate’) and the more complicated concept it represents, which results in higher earnings.
Watch the video below to gain a better understanding towards APR and APY:
What is the best way to compare rates of interest?
You can see from the example that interest that is compounded can earn more interest. You should use the same terminology when comparing rates, as they are often presented as either APR or APY. Be cautious when comparing items, as you may be comparing apples and oranges.
A product with a higher APY may or may not generate more interest than one with a lower APR, but you can easily convert APRs and APYs using online tools if you know the compounding frequency.
When you look at crypto products that use APY and APR, such as crypto savings and staking, make sure to convert them to compare apples to apples.
In addition, when comparing two DeFi products with APY, make sure that they have the same compounding periods. If they have the same APR, but one compounds monthly and the other daily, the one that compounds daily may earn you more crypto interest.
Another critical factor to take into consideration when examining a cryptocurrencies is whether or not the return or yield projected in any fiat currency is referred to as APY.
Some product collaterals may use the term “APY” to refer to the rewards that one can earn in cryptocurrencies over the chosen timeframe, rather than the actual or forecasted return or yield.
It is critical to keep in mind that crypto asset prices can fluctuate a lot, and your investment (in fiat terms) could go up or down. As a result, even if you continue to earn an APY in crypto assets, the value of your investment (in fiat terms) may be less than the original fiat amount you invested.
To fully understand the risks involved and what APY signifies in that specific context, you must carefully examine the product terms and do your own research.
At first glance, APR and APY may seem confusing, but remembering that annual percentage yield (APY) is the more complex metric that includes compound interest makes it simple to distinguish one from the other.
Because interest on interest is always a higher number when interest is compounded more frequently than once a year, APY is always higher. It is crucial to check which rate you are using to calculate the interest you will earn when you are making inquiries.
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